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Benefits and Pensions MonitorHarnessing The Power Of Quantitative Investing
Maximizing value-added returns within the context of a risk budget is taking on growing importance for institutional investors as they cope with the multiple risks of managing an investment plan in an environment of low predicted capital market returns. The good news is that plan sponsors have more options than ever to choose from these days as the evolution of quantitative investing opens up new opportunities for customizing portfolios to meet specific risk/return objectives. Building on the discipline of indexing, quantitative strategies take this technique to the next level, drawing on scientific insights into market efficiency and innovations in risk modeling to make very efficient use of active risk. The result is an investment approach that combines the best that active and passive management have to offer, producing an outcome similar to what fundamental managers strive to achieve – excess returns (alpha) over an established benchmark – with tightly controlled tracking error risk. Quantitative strategies have proved their merits over several business cycles, consistently delivering superior, risk-adjusted returns. If your organization is concerned about risk, it may be time to consider whether these solutions have a role to play in your investment plan. Efficient Harvesting Of Alpha The search for alpha in the quantitative space begins with an analysis of the drivers of financial asset returns. These drivers, or ʻfactors,ʼ come from a variety of sources and include market and technical indicators, as well as the basic accounting and investment principles that guide fundamental active management. To evaluate how well a factor is likely to predict stock or bond returns in the future, quantitative managers use statistical tools to measure the correlation between that factor and excess returns. The results are built into an econometric model that scans financial markets for pricing inefficiencies – in other words, stocks and bonds that are too cheap or too expensive relative to what past experience suggests securities with these characteristics should be worth – that can be exploited for profit.
Real Advantage This combination of analytical rigour and computing power offers real advantages for investors whose primary concern is risk-adjusted alpha. Because a quantitative model can track a large number of factors and adjust its output in response to shifting market preferences for those factors, quantitative strategies tend to be less prone to the style and capitalization biases that characterize their fundamental active peers. And, because a model can incorporate the full benchmark universe of securities, quantitative managers can hold broader, better diversified portfolios than their counterparts in the active sphere. That gives them more opportunities to spot pricing anomalies and it allows them to take correspondingly smaller positions in each one. The upshot is a disciplined, low-risk strategy that can generate value-added under a variety of different market conditions. Well-constructed Portfolios Once a quantitative model has generated a set of excess return – or alpha – forecasts, managers implement the portfolio, adjusting for the desired level of risk and keeping transaction costs to a minimum. The number of variables to consider – hundreds of securities, each with its own risk profile, as well as transaction costs that can vary with the size of each trade – is too great for a single individual to process. Instead, quantitative managers use mathematical programs to ʻoptimizeʼ the portfolio in line with risk constraints and expected implementation costs. The result is a portfolio with well defined risk properties that does not take unintended bets and that constantly verifies and controls the risk associated with each active position. This emphasis on risk-adjusted returns is built into one of the principal performance measurement tools for quantitative strategies – the information ratio (IR). The IR divides the excess return managers achieve by the tracking error they incur, thereby capturing how much value managers added for each additional unit of risk they took. Risk Parameters For institutional investors with a finite risk budget, quantitative investing offers an attractive method for achieving excess returns within clearly specified risk parameters. Furthermore, for organizations that are already operating in the long-only quantitative space, it is not a big step conceptually to transition into long-short strategies which also have applications in a portable alpha context. That is the great appeal of the quantitative approach. It opens the door to a rich array of solutions that enhance the ability of investors to fine tune their portfolios to fulfill precise asset and liability management needs. Jean Masson is vice-president and director, head of Montreal Research, at TD Asset Management Inc. This article has been provided for information purposes only. The information has been drawn from sources believed to be reliable, but is not guaranteed to be accurate or complete. TD Asset Management Inc. and The Toronto- Dominion Bank assume no responsibility or liability in respect of the information provided. |
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